Has Gold Lost Its Shine? – 2014

December 19, 2014

Since last reporting on gold in our second quarter 2013 Wescott Investment Commentary article, “Has Gold Lost Its Shine?”, the price of gold bullion rose to $1,419.50 on August 28, 2013 before falling to $1,204.50 by year-end. In 2013, gold was down 27.3%, its biggest decline since 1981 (during which it was down 32.6%). Investors in gold-backed exchange-traded funds (ETFs) have been hardest hit by declining investor interest in gold. A combination of better economic data and low inflation has driven investors to seek higher-returning asset classes, including equities.According to the World Council Gold Demand Trends Full Year 2013 report, gold ETF and similar products suffered outflows that resulted in a sale of 881 tonnes of gold in 2013. This trend continued during the first half of 2014, as ETFs were forced to sell 40 tonnes of gold through June 30, 2014.

Historically, the price of gold has been very volatile due to investor sentiment and fears about the economy. In the chart above, the most remarkable period for gold was in the period following the credit crisis of 2007-2008. The price of gold hit its high in early September 2011 during the sovereign debt crisis, following Standard & Poor’s downgrade of U.S. Treasury debt and with the threat of a federal government shutdown. Prior to 2006, gold prices stayed in a narrow range.

Investors usually buy gold when there is a great deal of uncertainty in the market and about the economy because they fear the possibility of really bad outcomes. Buying gold is, in essence, a “short against the dollar” trade. When economic and market conditions stabilize, investors typically sell gold to invest in asset classes expected to have a higher return.

Gold as an Inflation Hedge
Traditionally, gold’s role as an inflation hedge is weak. The price of gold does not always move in the same direction as inflation, as illustrated in the chart below, which compares the change in gold prices to the change in the Core Consumer Price Index (CPI) as the measure of inflation.

From a statistical perspective, gold has had a very weak positive correlation of 0.11528 (monthly) to inflation for the period of January 1979 through September 2014. Correlations can range from +1 to -1. If two variables are positively correlated and move in lockstep, the number should be close to +1; in contrast, a correlation of -1 indicates that they move in opposite directions.

Gold Has Failed as a Safe Haven
In the past, when the stock market has declined, gold has not proven a reliable safe haven. In the chart that follows, please note the frequency of negative returns for the price of gold. For the period of 1979 through 2013, gold had negative returns in 14 years, while the S&P 500 Index had negative returns in six years. As a standalone asset, gold exhibited greater volatility and a wide range of returns, from +126.5% in 1979 to -32.6% in 1981. Historically, the price of gold has been extremely volatile due to shifts in investor sentiment and periodic fears about the economy.

Gold has not behaved as expected during 2014, which to date has seen a series of geopolitical events which would have typically generated demand for gold. These global events include Russia’s annexation of Crimea, the crash of Malaysian Airlines Flight 17 (shot down by a missile in Ukraine), thousands of rocket strikes in

Gaza and Israel, and the increasingly violent actions of the barbaric terrorist group, the Islamic State in Iraq and Syria (ISIS). Despite all of these events, gold has been in a downward trajectory since March 2014. Year-to-date returns have been relatively flat, up only 1% year-to-date through September 30, 2014.

The Supply and Demand for Gold
The World Gold Council (www.gold.org) reports that there were approximately 177,200 metric tons of gold above ground as of December 2013. Based on the $1,216.50 price per ounce at the end of the third quarter 2014, the total value of the gold supply is approximately $6.9 trillion. Calculation methods vary about how to visualize the quantity of gold that has been mined; one calculation is that an Olympic-sized swimming pool could hold 48,250 metric tons of gold. Using that measure, all the gold that has been mined through December 2013 would fit in 3.67 Olympic-sized pools. The chart below provides the sources of demand at the end of the second quarter 2014, according to the World Gold Council.

During the second quarter of 2014, demand for gold decreased by 16% from second-quarter 2013. Consumer purchases in the form of jewelry were almost a third lower. Consumer demand is driven by Asia, with India and China accounting for 30% and 28%, respectively. Indian investors were constrained by a ban on coin imports and uncertainty about the election that culminated in Narendra Modi becoming India’s new prime minister in May. Chinese investment demand was constrained by uncertainty about future gold prices amid a recovering economy and a pullback from the strong demand of 2013.

Within technology, copper and silver are replacing gold in various industries (primarily telecommunications, transportation and information technology) for use in complex circuitry and for bonding wire for electronics. These replacements have resulted in a decline in this category versus last year.

The Impact of ETFs
We suspect that gold-related ETFs have changed the dynamic of investing in gold. As mentioned earlier, gold was down 27.3% in 2013. In the chart below, we illustrate the distribution of returns of the gold-related ETFs and gold bullion in 2013. Since gold does not generate any income, ETFs that own the physical asset have no cash to use for costs and/or reserves for redemptions. Strategies that employ leverage have additional risks, which can magnify performance in both directions. For example, in 2013, the Direxion Daily Gold Miners Bear 3X ETF returned 181.4% and the Direxion Daily Gold Miners Bull 3X ETF was down 95.1%.

Year-to-date through September 30, 2014, gold was up 1.0%; in contrast, the returns for the 23 gold-related ETF funds domiciled in the U.S. ranged from up 11.5% to down 35.7%, with an average return of -2.7%.

The Complexities of Direct Investments in Gold
There are many reasons why investing in gold bullion requires a thoughtful approach. For instance, there are storage and insurance costs to take into account. Also, bullion is considered a “collectible” by the IRS—under current tax law, gains are taxed at a rate of 28% if held at least 12 months; otherwise, the gain is taxed as ordinary income.

Wescott’s Approach to Investing in Gold and Commodities
During 2011, we researched the broader category of global natural resources for exposure to tangible assets and to complement the gold exposure we have embedded in our portfolio (primarily in the First Eagle Global and First Eagle Overseas portfolios). As of September 30, 2014, First Eagle Overseas had 9.6% invested in gold-related holdings, of which 4.7% was in gold bullion. We added RS Global Natural Resources to our model in early 2012 in order to achieve exposure to diversified commodities (not all of which are exchange-traded) that are expected to be needed for global consumption and infrastructure. RS invests in energy, rare earths, salt, metals and materials needed for alternative energy, agriculture, construction and consumer products. In addition to offering a more diversified portfolio, RS employs a more conservative approach by owning low-cost producers and by investing only in companies that have demonstrated themselves to be strong capital allocators and in which RS can invest at a discount to fair value. As of September 30, 2014, RS had a 5.5% weighting in two gold mining companies: Goldcorp Inc. (3.6%) and New Gold Inc. (1.9%); these two holdings comprised their overall allocation to precious metals. RS looks for gold mining companies that can invest when gold prices are in the $1,250 to $1,350 range, since these companies can make money even when prices drop. According to RS, many gold companies are now delaying projects for the next 12 months because it is not economical for them to invest at current prices.

Wescott’s Conclusion
Since our last update, the dollar has become stronger and interest rates have become more skittish in response to global developments and due to concerns about the Fed’s next steps. Concerns about a global meltdown have abated, and investors are now facing subdued inflation and uncertainty about when and by how much interest rates will start to climb higher. These conditions make a poor case for holding gold as an investment.

To summarize, gold has not been a reliable hedge against inflation or a safe haven. The speculation by hedge funds and ETF traders has changed the dynamics of gold pricing, driving the gold bubble to its peak in September 2011, and contributing to its sharp decline in 2013. We recognize the long-term needs for gold within a global economy; however, we prefer to rely on the judgment of our managers to determine the underlying allocation to gold within the broader category of commodities, based on the fundamentals of pricing and trends in supply and demand.

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